Is it a sugar rush or something more sustainable?
Economic growth in the United States was strong during the second quarter. Gross domestic product (GDP), which is the value of all goods and services produced in the United States, grew by 4.1 percent. That’s the fastest growth in four years, reported the BBC.
The news was received with varying levels of enthusiasm. President Trump said the gain is “an economic turnaround of historic importance” and thinks the economy should continue to grow rapidly, reported Shawn Donnan in Financial Times.
Economists were less certain. They think second quarter’s GDP gains were underpinned by one-time factors. These included high levels of profitability attributable to last year’s corporate tax cuts and an increase in exports as U.S. producers and their buyers abroad tried to avoid upcoming tariffs, reported Financial Times.
Another consideration is the business cycle. The business cycle tracks the rise and fall of a country’s productivity over time. The U.S. appears to be in the latter stages of the current cycle. John Authers of Financial Times explained:
“…President Donald Trump’s self-congratulation yesterday was fully merited. Things are going according to plan. This business cycle looks ever more like a normal one, which is a fantastic and welcome development after an epochal crisis and then a decade of doldrums…The advent of a normal cycle is itself a problem because a normal cycle terminates with high interest rates and declining growth. The president has voiced his disapproval of these things, but they are the logical and sensible consequence of the economic developments that are now unfolding.”
In the United States, the Dow Jones Industrial Average and the Standard & Poor’s 500 Index moved higher while the NASDAQ Composite gave up some ground.
Last week, there was some good news and some notable news.
Here’s the good news: Corporate earnings have been strong. As of July 20, 17 percent of the companies in the Standard & Poor’s 500 Index had reported second quarter results. More than 85 percent of those companies reported positive earnings surprises, according to FactSet, which means they earned more than expected.
“It appears the lower tax rate is more than offsetting the impact of rising costs, resulting in a record-level net profit margin for the index for the second quarter,” explained FactSet.
Here’s the notable news: U.S. stock markets largely ignored a slew of domestic and global issues to finish up a basis point or two last week. (Performance was flat when you round to one place, as we do in the table.) Barron’s reported:
“President Donald Trump took on the Federal Reserve, telling an interviewer that he’s ‘not happy’ about rising interest rates, the kind of meddling we haven’t seen in a while. We also had the usual trade war concerns, as the president and his advisors talked about the need to take on what they consider China’s unfair trade practices. China’s yuan, meanwhile, tumbled in a way that was a little too reminiscent of August 2015, when its slide caused global markets to shudder. Those concerns, however, were offset by strong corporate earnings.”
The U.S. bond market has been less sanguine than the U.S. stock market. Debate has focused on the flattening yield curve. The yield curve reflects the difference in yield on U.S. Treasuries from short- to long-term. Normally, investors expect to earn higher yields when they lend their money for longer periods of time (e.g. invest in longer-term bonds).
At the end of last week, two-year U.S. Treasuries yielded 2.6 percent and 30-year Treasuries yielded 3.0 percent. Some say when short-term rates rise above long-term rates, inverting the yield curve, recession is ahead.
Investors are becoming more discriminating.
Trade tensions escalated as the U.S. administration expanded tariffs on Chinese goods last week. You wouldn’t have known by watching the performance of benchmark indices, though. Just four of the 25 national stock market indices tracked by Barron’s – Australia, Italy, Spain, and Mexico – moved lower.
However, if you look a little deeper into the performance of various market sectors, you discover an important fact: The market tide wasn’t lifting all stocks.
It has been said a rising tide lifts all boats. When translated into stock-market speak, the saying becomes, ‘A rising market tide lifts all stocks.’ In other words, when the market moves higher, stocks tend to move higher, too. That wasn’t the case last week.
Barron’s reported investors have become more selective:
“We went from a market where everything moved largely together to one where sector fundamentals began to matter more than where the S&P 500 was going...At the sector level, it’s apparent that no one has been ignoring tariffs. While the S&P 500 has gained 1.7 percent over the past month of trading, industrials and materials have dropped 2.5 percent, while financials have slumped 2.9 percent, hit by a double whammy of trade fears and a flattening yield curve. Utilities and consumer staples have outperformed, gaining 8.1 percent and 3.5 percent, respectively.”
Utilities and Consumer Staples are considered to be non-cyclical or defensive sectors of the market because they are not highly correlated with the business cycle.
Defensive companies tend to perform consistently whether a country’s economy is expanding or in recession. For example, a household’s need for power, soap, and food doesn’t disappear during a recession. As a result, the revenues, earnings, and cash flows of defensive companies remain relatively stable in various economic conditions.
In addition, the share prices of these companies tend to be less susceptible to changing economic conditions. Defensive stocks tend to outperform the broader market during periods of recession and underperform it during periods of expansion.
What a rollercoaster of a quarter!
When it comes to the American Association of Individual Investors (AAII) Sentiment Survey, respondents tend to be more bullish than bearish about U.S. stock markets. The survey’s historical averages are:
As the second quarter of 2018 began, investors were feeling less optimistic than usual. (About 36.6 percent were bearish and 31.9 percent bullish.) Their outlook was informed by a variety of factors, according to an early April article in The New York Times, which said:
“First there was the risk that the economy might be growing too fast, which could prompt central banks to hike interest rates sooner than expected. Then there was the risk of a trade war ignited by the White House imposing tariffs on certain products, an action that quickly prompted countries like China to erect trade barriers of their own. Next came the threat of a government crackdown on technology companies, after revelations of their misuse of customer data.”
As the quarter progressed, investor optimism increased on signs of economic strength. In early June, CNBC reported the economy appeared to be “operating close to full employment, with an unemployment rate at 3.8 percent, inflation still hovering at or below 2 percent, and business and consumer confidence strong.”
Robust corporate earnings helped spur optimism, too. FactSet Insight wrote, “The S&P 500 reported earnings growth of 25 percent for the first quarter – the highest growth since Q3 2010.” In mid-June, the AAII survey showed 44.8 percent of respondents were feeling bullish, 21.7 percent were bearish, and 33.5 percent were neutral.
As talk of tariffs and trade wars resumed, investor optimism plummeted. By the end of June, just 27.9 percent of respondents were bullish and more than 39 percent reported they were feeling bearish. AAII explained:
“Many – but not all – individual investors anticipate continued volatility and/or think that the current political backdrop could have a further impact on the stock market. Trade policy is influencing some individual investors’ sentiment as well. While many approve of the Federal Reserve’s plan to continue gradually raising interest rates, some AAII members are concerned about the impact that rising rates will have. Also influencing sentiment are valuations, tax cuts, earnings growth, and economic growth.”
Despite a downturn in bullishness, major U.S. stock indices moved higher last week.
There’s a bear in China – and it’s not a panda.
The Shanghai Stock Exchange (SSE) Composite Index, which reflects the performance of all shares that trade on the Shanghai Stock Exchange, dropped into bear market territory last week, reported CNBC. The Index has fallen more than 20 percent from its previous high. It appears some investors saw an opportunity and bought the dip since the SSE Index bounced higher last Friday, gaining more than 2 percent.
Slower economic growth and rising trade tensions were responsible for much of the red ink in China, reported Barron’s, but the Chinese government may be playing a role, too:
“What’s got global market watchers worried is that China’s stocks are sliding in tandem with its currency, the renminbi or yuan…That suggests China is using the exchange rate as a weapon. ‘The most effective way for China to retaliate [against] rising U.S. tariffs is to weaken the yuan,’ according to the July Bank Credit Analyst. That could roil financial markets, however. The dual declines in China’s equity market and currency are raising concerns of a repeat of 2015. Treasury strategists at NatWest Markets recall that the drop in the yuan that summer sparked severe equity market losses, including a 10.5 percent correction in the S&P 500.”
That may explain, in part, why U.S. Treasury bills were so popular last week, although it probably didn’t hurt the yield on short-term Treasuries was roughly equivalent to the dividends paid by the Standard & Poor’s 500 Index.
The coming weeks may deliver more excitement than Fourth of July fireworks.